Confidence Game - Christine Richard [131]
Chapter Twenty-Two
Time Runs Out
We are seeing real harm not only to investors and governments but to the capital markets, and therefore it is time for people to act.
—NEW YORK GOVERNOR ELIOT SPITZER, FEBRUARY 2008
IN A CORNER OF the bond market where municipalities and other issuers sell so-called auction-rate securities—a $400 billion market—another crisis had been brewing for months. By late January 2008, it was about to boil over.
Auction-rate securities (ARS) were purchased by wealthy individuals and corporate treasurers as a safe, short-term investment for cash. The securities were rated triple-A, thanks to bond-insurance policies, so there was no apparent credit risk. ARS had long-term maturities, but the interest rates were reset at regular auctions, giving investors the opportunity to trade out of the securities every few weeks. There was no guarantee that anyone would buy the securities at the next auction, but they always had in the past. On occasion, banks underwriting the securities had quietly stepped in to support the market when bids at auctions were thin.
If no one bid for an ARS when it was reauctioned, then the dealer would increase the yield on the security until it reached a specified cap. In some cases, these caps were set as high as 20 percent. If no one bought at the maximum yield the auction would be deemed a failure, the existing holder would be stuck with the securities, and the issuer would be stuck paying an astronomically high interest rate. Banks made sure this never happened.
That was, until July 2007, when the credit-rating companies began to downgrade subprime securities and collateralized-debt obligations (CDOs) and things began to go drastically wrong.
At just about this time, two brothers from New Jersey sold their family’s shipping business, Maher Terminals, for $1 billion. They turned over $600 million of the proceeds to Lehman Brothers to invest while they contemplated a future as entrepreneurs and philanthropists. Lehman parked their money in auction-rate securities, including securities issued by the bond insurers.
These securities—called contingent preferred stock put facilities—were created to provide the bond insurers with additional capital if their claims-paying resources ran low. The proceeds of the bond issue were held in a trust that invested in safe securities such as Treasuries. If the bond insurer needed capital, it was permitted to sell the safe securities, replacing them with newly issued preferred shares. Of course, if a bond insurer were in the position of needing to raise capital, those preferred shares probably weren’t going to be worth much.
In theory, the securities made perfect sense. The Maher brothers got a slightly higher yield on their funds for taking what seemed like a very remote risk—a capital crisis at a triple-A-rated bond-insurance company. In practice, these securities were a ticking time bomb for the capital markets.
If investors started to worry about the bond insurers, these securities would become impossible to auction. Once investors balked at buying the securities, there was a danger they would rethink the entire ARS market. After all, the only reason most of these securities carried triple-A ratings was that they were insured by bond insurers. If a failed auction began with a bond insurer’s own securities, there would be no telling how far it could spread. “Failed auctions are typically self-perpetuating,” the Maher brothers’ attorneys stated in a complaint filed with the Financial Industry Regulatory Authority in early 2008 against Lehman. “That is, once an auction fails it is unlikely that it will subsequently succeed at a later auction in the absence of intervention.”
On August 6, 2007, the auction of contingent preferreds for a small bond-reinsurance company called Ram Re failed. Even though the